As parents or grandparents, we want to do what is best for our children and grandchildren. We want them to enjoy the gifts we have given them in our lifetime – family traditions, relationships and values – and we also want our financial legacy to pass on to them without complications. But if we don’t manage our planned giving thoughtfully, we could leave future generations with unexpected challenges.
In my practice, I have seen many ways for individuals to transfer their wealth from one generation to the next, but in my opinion there are only a handful of vehicles that effectively transfer financial gifts to future generations during our lifetime. My top recommendations are UTMA/UGMA accounts, 529 accounts, IRAs, and irrevocable gifting trusts.
Which of these options you should choose will depend on the degree of control you wish to retain, the purpose of your donation, and the amount of the intended donation. Let’s review the pros and cons of these different models to understand how to work with legal and financial advisors to provide for our heirs.
The easiest method of gifting is to create a custodial account under your state’s version of the Uniform Minors Transfer Act or Uniform Gifts to Minors Act. These accounts exist for the purpose of allowing gifts to be set aside for minor children who otherwise could not legally own significant property. Deposit accounts allow you to designate someone (including yourself) to manage the funds offered until the child is of age, most often 18 or 21 years old.
The advantage of this approach is that it takes almost no effort to create such accounts. Accounts contain standard provisions in accordance with local law, and they are as easy to set up as asking your bank to set up a deposit account for you.
Custody accounts, however, are considered taxable to the child. This could complicate matters if the investment income triggers a “child tax”, potentially making the child’s income taxable at an even higher rate than their parents and in accordance with trust income tax brackets. not ceding. As concerning as federal tax is, keep in mind that your state may have a lower threshold that could also trigger state “child tax.” Discuss these issues with your lawyer or tax advisor before setting up a deposit account.
An even bigger downside to custodial accounts is that once the child turns 18 or 21, that account becomes theirs, period. If you are planning to make a large donation or multiple donations, it could mean that a recipient as young as 18 wakes up one day with immediate access to a small fortune. How and whether this fortune is managed and used responsibly depends entirely on this child. Is this your intention?
Even if you want to undo what you’ve created when you see this child reach their late teens, you may end up opening a legal Pandora’s box. Once funds are transferred to a custodial account, those funds must be used for that child. Even if the child is unable to manage the assets, the account should still be used for their benefit. Failure to do so could expose the custodian to legal action on behalf of the minor alleging that the account has been mismanaged.
The bottom line is that custodial accounts should only be used when the total amount offered is relatively small.
529 plans are an increasingly popular option for passing wealth to the next generation. The purpose of 529 accounts is for gifted funds to be used for education expenses, but note that there is a long list of expenses that can be referred to as “educational expenses.” It is therefore important to familiarize yourself with what a 529 plan distribution can be used for.
The main advantage of a 529 account is that any income from transfers into the account is free from federal income tax – as long as the distributions are used for qualifying expenses. These winnings may also be non-taxable under local and national laws, but you should confirm this with your advisor. A 529 account, like a deposit account, lets you designate who will handle the funds, preventing recipients from having direct control over the money. Unlike deposit accounts, 529 recipients never have an absolute legal right to receive the funds.
Even better from a tax perspective, contributions to a 529 account are still eligible for the annual gift tax exclusion, but they provide additional gift and estate tax planning opportunities, such as you allow advance giving for up to five years. without using your lifetime tax exemption, sometimes referred to as “superfunding”.
Another important benefit of a 529 account is that you can change the beneficiary of the account, providing flexibility when additional children or grandchildren are born (or do not pursue higher education as planned).
Overall, a 529 plan account is a great tool for those looking to save for education expenses, and it offers the convenience of a single plan that can be used for the whole family. These accounts are easy to set up, with standardized provisions governing their structure.
IRA for children
A child IRA is no different than an adult IRA, as far as the IRS is concerned. Contributions to an IRA must be made with earned income and cannot be funded with donations. When a child is earning income they don’t need immediate access to, an IRA can still have significant long-term benefits.
Just like an adult IRA, a child IRA can be set up as a traditional or Roth IRA. A traditional IRA allows for an immediate deduction of income taxes when contributions are made, with no principal or income taxed on that child until they withdraw funds in the future (hopefully in the future). time of retirement). In contrast, a Roth IRA offers no immediate tax deductions, but any income earned on the assets of a Roth IRA is tax-exempt, including when distributions are made to children in the future, as long as he is at least 59.5 years old and has held a Roth account for at least five years.
Although there are contribution limits and other requirements to consider, the general rule is that a Roth IRA is the preferred approach when the employee expects to be in a higher tax bracket at retirement than he is now. It’s safe to assume that most younger children with earned income earn more (and face higher tax brackets) in their later years. As such, most children’s IRAs will take the form of a Roth plan.
As with custodial accounts, these accounts ultimately belong to the child and must be used exclusively for the benefit of the child. Since beneficiaries will ultimately exercise control when they reach the age of majority, those creating IRAs for their heirs must be confident that they will be able to resist the temptation to empty their accounts sooner, triggering 10% penalties for withdrawal before retirement age. For this reason, gift givers should carefully consider the implications before establishing IRAs for children.
The most versatile way to give gifts to minors is to establish a trust. There is no one-size-fits-all approach to setting up a trust, and tax rules can change and be difficult to understand. For this reason, these trusts can be complicated and should only be created with the help of an estate and trust lawyer.
A trust is a private agreement that names a trustee who will manage the assets of one or more beneficiaries. The terms of the deal can be almost anything you can imagine. Depending on state law, trusts can be structured to be fully protected for the life of a beneficiary (i.e. not subject to claims by creditors of that child or a divorced spouse) . This provides great flexibility, allowing gifts to be used for as specific or as varied a purpose as you wish.
Unlike custodial accounts and other standardized accounts, there is no age or requirement for a beneficiary to gain full access and control of their fund. It entirely depends on the person who created the trust. This person can also decide what happens to the remaining funds after a beneficiary dies, instead of letting the beneficiary make that decision.
A trust might be the only advisable way to donate in special circumstances, such as a beneficiary with special needs who must be able to maintain public benefits such as Medicaid. With careful structuring, trusts can deal with contingencies and specifically achieve intended goals better than other types of accounts.
The biggest downside is that trusts can be expensive to set up and must be done with the help of a knowledgeable estate planning attorney. With larger estates, there may also be tax considerations: the income of the trust may be taxable as a separate entity, it may be taxed directly to the donor, or it may even be taxed to the beneficiary.
The bottom line is that trusts allow donors to structure their gifts as they see fit. Trusts can be created for a single beneficiary or for a group of children or other descendants, increasing investment power through the pooling of assets. Given the cost of establishing a trust and the more complex rules, trusts are best for large gifts that will justify the time and expense required to create and figure out how to administer the trust.
The tail tends to wag the dog when it comes to giving presents. It is important to stay current with laws, especially tax rules, to maximize the value of gifts and ensure desired results.
Even the most common gifting strategies involve overlapping skills and knowledge of lawyers, accountants, and wealth management advisors. These are complex, multidisciplinary issues, so be sure to work with experts in these disciplines.
Founder and Partner, Hales & Sellers PLLC
Jack Hales is a founding partner of Hales & Sellers PLLC and is certified in estate planning and probate law. Hales primarily focuses on the areas of estate planning and probate, including representing executors, trustees and beneficiaries in uncontested and contested estate and trust matters.